I had some difficulty in understanding this paragraph in an article explaining the movie, 'The Big Short':

Most of us when buying a house take out a loan (mortgage) and pay back
the purchase price over time. We also usually hope that the value of
the house we buy will go up not down. In the US, many people had
come to assume that house prices would always rise, because they’d
risen without fail for many years. This attitude saw mortgage lenders
offering riskier and riskier loans to people who’d only be able to
make payments if the price of their house continued to increase.

2 Answers
2

If a mortaged house decreases its market price after the mortage was made, the bank is in risk in case of default - it might be unable to recover the amount it loaned. In practice this doesn't change the amount you owe to the bank or the monthly payment - you owe the same regardless of the value of the house after making the mortage.

I believe the author meant that the people the banks were lending to would only be able to afford to pay the mortages if the economy kept on booming, and they would remain employed.

Banks charge interest to cover costs. Among these costs are the costs of delinquent loans. Suppose your bank has lent you X dollars, and your collateral is a house worth X dollars. The bank has some risk of your loan becoming delinquent. If your chance of delinquency decreases, the bank should be willing to let you pay a lower interest rate. If your house has increased in value to 2X dollars, it is less likely that you will default on your X dollar loan. So the bank could accept a lower interest rate.

Despite being able to do so, I am not sure why the bank would voluntarily accept to take less money. Perhaps it is in the contract that they have to, or you can threaten defaulting or early repayment. (Perhaps it is a subprime mortgage bond and reevaluation is in the bank's interest, as it can sell the bond at a higher price.)

Either way, the bank reassesses your risk and gives you a lower interest rate. Many people taking out loans were expecting this and accepted teaser loans that charged lower interest rates in the first few years of the loan. After these years the interest rates would increase to levels they could not afford - unless they refinanced the loans. They could only do this on good terms if the value of their houses went up.

I could not find an article that explains the basics of refinancing, but here is a paper on its effects: